Tuesday, September 27, 2011

FUEL-O-NOMICS

One question that has been in the minds of most of
us: Why are gas prices so high? There is also another thing that has puzzled me
quite often: Why are they so different? Yesterday evening we were almost out of
gas (me and my car) when I started from office. I checked the gas station nearby and it read
$3.89 per gallon. I remembered seeing $3.79 somewhere near my house, so I kept
driving. I was about to fill my gas at that station when my iPhone informed me
that 4 miles away, gas was $3.72. I live in Chicago suburbs and Gas Buddy tells me that
fuel costs $4.09 in downtown. So within a radius of about 15 miles I was able
to see 4 different prices for fuel. And we are just getting started here. If
you look at US national averages: Gas costs around $3.9 on average in the West
Coast, Mid West comes close with $3.7, Utah/Colarado being in the center come
in at about $3.5 whereas if you go down
South to Texas, gas is relatively cheap at $3.1. Now that is a $1 differential
for just 1 gallon and it is fairly significant. And within regions too the
prices fluctuate as much or more over the year. I wanted to make sense of all
this and was going crazy. So I decided to catch Professor Eisenkleiftovich
again and pick his brain on this topic.

Me: Professor. Why are you
looking so dejected?

Prof: Err… Did you hear that a
few neutrinos have outpaced the speed of light by 60-billionth of a second? I
never imagined Einstein could be proved wrong.

Me: But Prof: That could just
be a false alarm. There have been quite a few of them before.

Prof: Hmm.. you are right. And I
hope so too. Otherwise I will have to revisit and redo all my research again as
they all have the theory of relativity as the foundation stone. Either way, an
interesting space to follow! You tell me kiddo. What are you upto?

Me: These fuel prices have
been intriguing me for a while now. I have always thought that they are based
mostly on the price of crude oilbut I don’t believe that theory supports the
fact that different regions in a country have different gas prices. Could you
shed some light on this?

Prof: Sure. You have the common
misconception that most people have. To be precise, today you are just 65%
correct when you say fuel prices swing exactly with prices of crude oil. There
is more to it. Gas is just like any
other consumer product and there is a supply chain that sets the price of the
product. Here is the entire pie which tells you where each dollar you spend on
gas goes:

Me: Hmm…. That is interesting
to know. But still it doesn’t solve my confusion about global price
fluctuations and regional differences in fuel costs.

Prof: Patience, my boy. Let me
take up your global confusion (err..fluctuation) first. As you see the biggest
slice is still crude oil and its price is controlled by the classic supply and
demand principle. Demand here is straightforward: World Economic Growth. It is
driven by the increase in the number of people who drive! Developing nations
like China and India have an
expanding middle class who are likely to use more gasoline over time. And don’t
forget the US
which has a whopping 86,000 miles of interstate highways and consumes 178
million gallons of gasoline each day. Which is precisely why you will be
surprised to note that US imports around 11 million barrels of oil and
petroleum products per week and still happens to be the 3rd largest producer of
crude oil!

Me: Whoaa… I didn’t know that.
No wonder the Strategic Petroleum reserve is a big thing. But my heart goes out
for the Arctic National Wildlife Refuge. Anyways, what is the supply side
story?

Prof: Hmm… ever heard of OPEC.
It is the single largest entity impacting the world's oil supplies: The
Organization of the Petroleum Exporting Countries (OPEC), a consortium of 13
countries: Algeria, Angola, Ecuador,
Indonesia, Iran, Iraq,
Kuwait, Libya, Nigeria,
Qatar, Saudi Arabia, UAE and Venezuela. Together, these 13
nations are responsible for 40 percent of the world's oil production and hold
the majority of the world's oil reserves. They have the switch to control crude
oil prices. When OPEC wants to raise the price of crude oil, it simply reduces
production. This causes gasoline prices to jump because of the short supply
as well as the possibility of future reductions. When oil production dips, gas
companies get nervous. The mere threat of oil reductions can raise gas prices.

And apart from that, world events like military
conflicts in oil zones, weather calamities like hurricanes in offshore drilling
patterns and seasonality (summer for example where people drive more) can also
cause fuel prices to shoot up.

Me: Now I get this completely.
But what about the local piece? Why do gas prices vary from state to state?

Prof: There a few reasons, but taxes
probably are the biggest factor. Distance from oil refineries can affect prices
too. That is why places that are closer to the Gulf of
Mexico enjoy lower prices due to low transportation costs. Hence
the $3 in Texas compared to a $4 in San Diego. And then there isregulationthat differs
across different states. California
has stricter cleaner burning fuel requirements while Mid West has the use of
ethanol requirement. That explains the higher fuel prices in these regions
relative to the rest of US. And last but not least, local competition among gas
stations can also drive price down within a region.

And to bust the last myth: most people think that gas
stations make a good cut due to fuel price fluctuations. Remember that 8% of
the pie is split between distribution, marketing and the gas station. And then
there is competition. So now you can see that they typically just add a few
cents per gallon (max a dime)!

Me: Wow… that was good stuff. I feel a lot more
educated and oil-savvy. Thank you for enlightening me in such an entertaining
way. Good luck on your Einstein bet though. You think he will once again stand
the test of time (and light)?

Prof: Of course I do. I would go
ALL-IN on that one! I don’t want to rewrite all my theories, for Christ sake!